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of all guest columns written by Dennis C. Butler, CFA

The economic and financial market calamity of the early 1930s traumatized the investing public for decades thereafter, leaving an entire generation viewing Wall Streets
activities with skepticism, if not downright antipathy. Even those born long
after those harrowing times came to share their elders' condemnation of the stock market as a disreputable place, a
"rich man"s game —¯ dominated by insiders and manipulators.
Given the experience of the Depression years such attitudes might not be
surprising, but they were illogical, self-defeating, and economically costly — illogical because the returns from equity investments remained superior to almost anything else available to the average person over time, and self-defeating because investors, both individual and institutional, denied themselves an important avenue for achieving financial security for themselves or their beneficiaries. The economic damage came in the form of a higher cost of capital for business than would otherwise have been the case.

What brings this chapter of financial history to mind are reports offering evidence for a continued lack of enthusiasm for the stock market on the part of individuals, despite the dramatic rise in prices following the bottom of the market plunge in March 2009. Since then the S&P 500 index has gained over 170% through year-end 2013. A few figures reveal the extent of the disillusionment: from 2006 through 2012, individuals withdrew $451 billion from stock mutual funds as they added over $1 trillion to fixed-income funds. A turn in investor sentiment occurred in 2013 when about $60 billion was invested in stock vehicles, but enthusiasm waned over the course of the year. In contrast to traditional mutual funds, increasingly popular Exchange Traded Funds (ETFs¯) attracted $354 billion between 2006 and 2012, with another $86 billion being added through November 2013. Still, the public's interest in stocks remains relatively weak, and anecdotal evidence gleaned from
"man on the street"¯ interviews indicates continuing distrust. This data has puzzled market observers, since an upward-trending market usually helps people overcome their doubts.

History shows that market participants eventually get over the periodic episodes of market apoplexy and regain confidence (greed is a powerful incentivizing force), but not before inflicting considerable damage on themselves. Self-defeating behaviors are repeated as we saw most recently in 2008-2009 when fearful and distressed sellers exited stocks at low prices. Seeking
"safety"¯ or protection from the previous calamity, market participants typically flee to cash or unwisely flock to
"concepts"¯ that are largely speculative, whether the "Nifty Fifty"¯ of the early 1970s,
"portfolio insurance"¯ of the late 1980s, or dot-com sure-things a
decade later, all of which ended badly. This time around, participants looked to
gold and other commodities, "hedge" funds, and above all the "safety"¯ of fixed-income for their salvation.

The consequences of these choices are already being felt. Gold prices fell over 25% last year, the first down year since 2000.
"Hedgies"¯ added to a string of mediocre performances. A mini-rout in
bonds occurred last summer after the U.S. Federal Reserve hinted at the
beginning of an end to its easy money regime. The "reach for yield"¯ by some
individuals will likely cause much grief —
a portent of things to come appeared in a recent Bloomberg piece reporting the experience of investors who purchased shares in a certain type of real estate investment trust (a kind of security typically marketed to income-seekers) yielding 12%. That generous-sounding return came to naught when the shares lost 43% of their value in reaction to the anticipated changes in central bank policy, and a dividend cut is now possible. We sympathize with those who are in need of income and face the challenges of a zero-interest-rate world, but we have always felt that it is far better to spend a little capital if need be, that run the risk of losing a lot more.

Speculation about the aforementioned
changes in Federal Reserve policy dominated the financial news last year. Just
mentioning the possibility of a cutback in the level of monetary stimulus —
not a tightening —
brought disarray in fixed-income markets and a small setback for equities
during the summer months. In one of those odd twists so incomprehensible to the
uninitiated, when Fed officials actually did announce plans for "tapering" moves in December, stocks rose smartly and finished the year with gains ranging from 25% to 39% (depending on the index you favor). Thus continued the extraordinary run-up in stock prices since early 2009. During 2013 alone over $3.5 trillion was added to the aggregate value of the S&P 500 stocks.

Bonds were not a good place to be in 2013. From 1.8% at December 31, 2012, the yield on the 10-year U.S. treasury note rose to 3% a year later, indicating that bond prices declined. Returns on U.S. debt overall were negative, down 2.6%, while long-term U.S. bonds lost about 12%. This modest back-up in rates was not enough to cause much alarm; on the contrary, demand for debt securities remained strong across the spectrum and issuance of corporate obligations reached new records. Investors apparently now perceive a strengthening economy to be a more important factor than slightly higher interest rates, as an improved business environment usually means less credit risk. Significantly higher costs for debt might be a different matter, but that is not in the cards, according to the consensus view on Wall Street.

Looking ahead, rear-view-mirror analysts and money-managers see more of the same for the markets in 2014, although with greater
"volatility,"¯ perhaps less robust gains for equities, and "corrections" on the way.
(In other words, stocks might go up, but they could go down, too). Almost
universally, bonds are held in disfavor, a fact that in itself would make them
interesting were it not the case that fixed-income assets are still selling at
or near record prices (sometimes the consensus view turns out to be correct
after all). In keeping with our usual practice, we prefer to maintain silence
when it comes to soothsaying, taking instead a wait and see attitude. As Will
Durant once wrote, "One of the lessons of history is that nothing is often a
good thing to do and always a clever thing to say" —
lessons lost on most of Wall Street.

Economies of Scale

In a December piece reflecting
on the issue of financial "liquidity" the ease with which assets can be
bought or sold, or the availability of credit, The Financial Times' John Authers writes,
"scale in finance is not necessarily a good thing." The context of this comment was a discussion of
how in its drive to enhance liquidity, expand the availability of credit,
and increase the size of transactions that financial institutions can
execute, finance suffers a loss of "local knowledge"¯ that it sooner or later
lives to regret. For example, in the process of "securitization," computer
models define how mortgages on many different properties may be pooled into
one "asset,"¯ against which securities are issued using cash flow from the
pool to fund payments to buyers. Investors benefit from having access to a
"homogenous¯ security that is relatively liquid and easier to deal with
than the underlying mortgage contracts it represents. Mortgage lenders are
able to sell their mortgages to the securitizers, freeing-up their balance
sheets so they can offer more loans. More homebuyers are able to access
credit to purchase their dwellings. Everyone is happy, but knowledge of the
individual borrowers is lost in the shuffle, and that can cause major
problems, as we saw in the financial crisis that began in 2007. Pressures
and perverse incentives that became part of the homogenization and
securitization process led to practices that resulted in not even mortgage
originators having "local knowledge" of their mortgagees.

We believe this basic observation
applies to other areas in finance (perhaps to other endeavors as well),
including that of investment management. Like many people, we have often
noticed a negative correlation between the size of a business and the
customer's quality of experience. Take something as mundane as shopping at a
local hardware store versus a big-box retailer. The larger operation is
efficient, moves a lot of goods, and may offer modestly lower prices, but
there is nothing quite like dealing with someone who knows exactly what kind
of equipment you need and can offer advice on how to use it.

The
consolidation of the investment business into ever-larger entities has
created pressures for homogenization and uniformity in order to create
"products"¯ that can be easily pushed by armies of customer representatives
and advisors of every stripe. The investing public is led to believe that
these products are designed to meet the individual's goals and so-called
"risk preferences."¯ In reality, information is fed into computer-run
statistical packages that organize customer data according to well-defined
categories and spit out model portfolios designed to be appropriate for
each. Such is the cookie-cutter approach that has come to characterize an
industry organized to operate on a large scale ā€” an impersonal process that
fails to produce a true knowledge and understanding of individuals, and,
conversely, does not give those individuals real insight into how their
funds are being managed.

Homogenization reaches its apex in fund management,
in which, from the investor's perspective, no pretense of investment in
individual companies remains. A single fund can own shares in hundreds of
businesses whose individual characteristics can be subsumed in a single
title such as "growth."¯ Gone is the "local knowledge" of company
prospects. Such products, if used properly and simply, may be useful for
individuals of limited means seeking a home for savings over a long period
of time. The danger lies in investors' using such products more aggressively and not
getting what they think they are buying. ETFs, for example, are offered as a
way to invest in various markets (or slices of markets) as a whole, much as
traditional index mutual funds have done over a longer period, but with
greater “liquidity"¯ and ease of entry and exit. But when an ETF offers
exposure to an obscure, illiquid market (a so-called "frontier"¯ market, for
example), purchasers may find that their holding is not as easy to get out
of as they expected.

Size and scale of operation are not necessarily
impediments to good investment practice. We have long been convinced that
knowledgeable individuals have powerful advantages when it comes to
investing. If a fund is managed in the same manner as such an individual
would manage his or her own money, the advantages can be maintained.
Unfortunately, investment operations conducted on that kind of scale are few
and far between.

_____________

Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 27 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.

"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at: